July 1, 2005
A NEW QUARTER & THE SAME OLD QUESTIONS
The old logic that one shouldn't fight the Fed suffered yet another indignity yesterday. It was hard not to notice the divergence between the rise of the fed funds rate by 25 basis points to 3.25% and the decline in yield for the benchmark 10-year Treasury Note by roughly seven basis points to around 3.91%.
The reluctance of the bond market to support the central bank's efforts to raise the price of money across the yield and thereby move closer to inverting the yield curve is a familiar game of late. Therein lies the problem. Although the continued variance between short and long rates creates more tension with each passing day, the game must eventually end. The question is: which side will blink first? The Fed will either stop raising rates, and perhaps even lower them, as some are now predicting. Or, the bond market will send up a white flag and sell debt securities and thereby elevate long-term yields.
Once we know the answer with some degree of confidence, the implications for investment strategy will become clear. In fact, the bond market today is already reassessing its buying spree yesterday. The yield on the 10-year Treasury jumped above 4.0% in Friday for the first time in almost two weeks, in no small part due to the sharp rebound in the closely watched ISM Manufacturing Index for June after falling for much of the previous 12 months. Ergo: Is an even bigger blink in the bond market coming next week?
One day a trend does not make, of course. Meanwhile, the two opposing forces represent the frontline in the great debate as to whether the economy is poised to stumble or continue chugging along at a respectable, if not accelerating pace.
We know what the bond market's been saying on this score. But what of stocks? With the second quarter now history, it's a timely moment to review equity returns for clues about the future. An imperfect science, to be sure, and one that's further complicated by the ongoing conflict between short and long rates. Nonetheless, we dive in with eyes wide open and hubris trimmed to the nub in search of something, anything.
With that in mind, we're struck by the fact that the broad stock market indexes struggled to move higher in the second quarter. The S&P 500's total return was just 1.37% for the three months through the end of June, and year-to-date the benchmark is under water by –0.81%. If the economy's prospects remain encouraging, the equity markets have yet to be convinced.
Another sign that growth investing is stuck in neutral, at best, comes from a new report today that slices up the S&P 500 by factors (i.e., the key drivers behind success and failure in portfolios targeting the index). For the month of June, a fresh quantitative survey from CSFB reveals that price momentum and traditional value were number one and two, respectively, last month in manufacturing alpha, or the excess returns above the index's. What's more, CSFB informs that the biggest negative contributor to alpha creation last month was the expected growth factor followed by historical growth.
In other words, momentum and value are hot, growth is something less. That, at least, has been true via performance in the big-cap benchmarks of late. By contrast, the small-cap stock market is a bit more encouraging for both the economy and growth investing, or so one could reason by looking at the relevant indexes. Take note that the S&P Smallcap Index, otherwise known as the S&P 600, handily beat its big-cap sister in the second quarter with a 3.93% total return vs. 1.37% for the S&P 500. The small-cap premium also holds up year to date.
But when it comes to style investing, the race among the small caps is still too close to call. The S&P/Barra Small Cap Value Index won the race over its growth counter part in the second quarter, but not by much: 4.11% vs. 3.78%.
If investors still believe that growth will make a comeback relative to value, thereby reversing the trend of recent years, the best hope for confirmation at the moment resides in the small-cap market, according to S&P.
Quite often, confirmation of such a trend will be documented in other indexes. For example, value stocks' performance lead over growth stocks in recent years can found in benchmarks from the Frank Russell Co. Take the 12 months through June 30, 2005, a stretch when the big-cap Russell 1000 Value Index crushed its growth counterpart with a 14.04% total return vs. 1.67%. A similar outperformance for value can be seen in longer time frames too, and in the comparable S&P indexes as well.
But second-quarter results for Russell value and growth indexes contradict the message from the S&P style benchmarks. For the three months through June 30, Russell 1000 Growth posted a 2.46% total return, a comfortable margin over Russell 1000 Value's 1.67%. S&P, by contrast, says big-cap value won in the second quarter.
Some of the difference is simply differences in index construction. But if the growth factor is awakening from its long relative slumber, the case is still less than airtight and more than a little confusing. That said, given the extent of the bond market's reversal today, sending the 10-year Treasury yield well above 4% for the first time since mid-June, the forces of growth aren't dead yet.
Posted by jp at July 1, 2005 1:49 PM
The core of the Austrian school explanation makes perfect sense to me: to maintain the low funds rate the Fed has to pump in liquidity continually to buy up short-dated debt so as to keep the funds rate low. The narrowing gap, and coming inversion, is an inevitable consequence of this.
The direct expenditure of some of that new liquidity upon longer-dated govt bonds through capital-adequacy requirements and a dash of additional investment may be part of the explanation, but there is also the response of foreign countries to consider. Ordinarily the inflation of the dollar means a devaluation, but many other countries are keen to keep their own currencies pegged and/or undervalued so as to boost exports. Therefore, as a response to the Fed pumping in new cash these foreign countries' central banks must do likewise and then spend the money buying the USD in order to maintain its value relative to the other currencies. In turn, the cash is spent on US assets, particularly bonds because of restrictions on foreign investment in lands and equities etc.
A proper analysis of the volumes of cash involved, and of who is buying the bonds, would be needed to confirm this, but I find it compelling and am baffled as to why commentators find the ever-narrowing gap inexplicable. Not only is it in fact very explainable, it also implies that the gap will eventually become zero and then go negative because buying longer-dated securities makes for less roll-over expense. Of course, that expense provides a limit to the gap, but an inversion is still definitely on the cards until either the Fed allows the funds rate to climb to its own natural level (meaning that the Fed ceases to pump in liquidity) or the foreign countries involved halt their present currency practices.
You may find the stable of Australian economics writers (mostly Austrian-school) at Brookes News of interest, from whence I cribbed all the above. I'm not Austrian myself, but I find the school of great merit.
Posted by: John McVey at July 2, 2005 5:43 AM